Dynamic Capital Structure and Stochastic Interest Rates

Abstract

This study develops a model of dynamic capital structure in the presence of stochastic interest rates. Having separated the impact of firm characteristics, the paper shows that the optimal leverage and maturity are positively related to the short-term interest rates and negatively associated with the long-term interest rates. The volatility of interest rates affects the optimal leverage negatively. The optimal maturity is related to the volatility positively (negatively) when the yield curve is normal (inverted). The aforementioned are due to the changes in the firm's tax shields, bankruptcy costs and recapitalization costs caused by interest rate movements.